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ABC co. is planning to take over a currently operating telecom co.
Feasibility cost incurred in research amounted to $ 10,000/-. Further due difference audit was conducted which cost $ 2,000/-
Takeover amount has been fixed about $ 2M. Licence cost to be paid annually is $0.5M. XYZ co. has licence fee payable of $1M which ABC company has to pay immediately if takeover takes place.
If ABC co. invest in new project, they would have to use their warehouse which currently is being rented at $ 0.2M/yr.
Initial investment in working capital will be $ 0.5M, which would increase by $ 0.1M annually.
Sales revenue is expected to be $ 1M for year one and is expected to increase 10% annually.
Cost is expected to be $ 0.1M for year one and is expected to increase 10% annually.
At the end of year five capital investment is necessary of $ 3M. Current W.D.V of fixed assets of XYZ is $ 2M. capital allowance can be claimed at 20% on straight line basis.
tax rate is 30% and s paid one year in arrears.
Cost of capital is 10%.
Calculate NPV of next 5 yrs assuming life of the project.The licence fee is an outflow at time 0 of $1M.
(The question does not state whether or not it is tax allowable (which the real exam would state) – here you will have to state your assumption. If it is tax allowable then there will be a tax saving of $0.3M at time 2)The working capital is an outflow of $0.5M at time zero, followed by an outflow of $0.1M at times 1, 2, 3, 4, and 5.
(Usually we would assume that all the working capital came back as a receipt at the end of the project, but since it will continue then we would not)
The working capital flows are not tax allowable.Again, the question does not give enough information and so you have to make an assumption (and state your assumption).
If it is paid at the end of the year, then it will be an outflow at times 1, 2, 3, 4 & 5.
However, if (more likely) it is paid at the start of each year, then it will be an outflow at times 0, 1, 2, 3 & 4.In the real exam the examiner is usually very clear about this sort of thing (he will say whether it is paid at the beginning or end of the year). If (which is unlikely) he does not, then provided you state your assumption you will get the marks if you have done it correctly on your assumption.
thankyou Sir, for your help.
In question no. 34, Basril, from kaplan revision kit. the PI is calculated taking PV of the savings divided by investment. but the formula of PI in the book is given NPV divided by Investment.
the left over capital is also not utilised as according to text book, why ? as the left over capital need to be multiplied by PI, its not done in revision kit.
With regard to the profitability index, it can be defined either way – either PV divided by the investment, or (more sensibly) as NPV divided by the investment.
In some questions the examiner has done it one way, and in other questions the other way.
It does not matter – you will get full marks whichever way you do it (even though the answer is obviously different).
I hope you see that whichever way you define it, it does not change the order in which you will choose the investments.With regard to the left over capital when the projects are not divisible, the answer is that if you cannot use all the capital available then you do not borrow it!! There is no point in borrowing money (and paying interest) if there is nowhere to invest it.
Even if we have cash in the bank, the cash is effectively still being borrowed – the shareholders are entitled to it as dividend and so by keeping it we are effectively borrowing from shareholders.
If we have nowhere to invest the cash, then we should give it to shareholders as dividend. (And this occurs in practice – the company should only keep cash if they have somewhere to invest it (or expect to be able to invest it in the future) – if not then they should pay it to shareholders.
(Not for the exam, but Apple has lots of cash that they are doing nothing with at the moment. That is why there has been pressure from shareholders to pay it out as dividend, and that is why Apple has decided to pay more dividend!!)My question is from Kaplan Revision Kit, Question No. 35 ASOP CO.(DEC 09)
the question doesn’t state whether the licence fee is tax allowable or not. But, in solution part (a) there has been taken tax saving on the licence fee.
In part (b) the question ask for calculating NPV. in solution half of the calculation has been done at Discount factor of 11% and the half portion is taken from part (a) which has been calculated at the discount factor of 6 %. why ?
what if I do the part (b) calculation entirely taking D.F of 11%?
Part (a) assumed that the license fee is tax allowable. This is actually the most sensible assumption – you would expect all costs to be tax allowable unless told otherwise.
For part (b) it is no problem is you discount everything at the cost of capital – you would get full marks (and it is actually more sensible)
Hi,
I would like to ask regarding he NPV appraisal where the question does not require to round off to the nearest thousands, can i still round it off to thousands? And would be the workings showing hw the cadh flows being inflated will be given marks?You would not lose marks by doing things to the nearest thousand.
If you get the cash flows corrrect then you will get the marks. However it is always sensible to show some workings to prove you know what you are doing – if you have misread something or made a silly mistake, then you will get most of the marks if it is clear from your working that you understand what you are doing. If you get the figure wrong and there are no workings then you would get zero for that part.
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